Musings on Economics, Finance, and Life

Will Rising Government Debt Hurt Growth?

Every January America’s economists gather for their annual conference. There are far more papers than one could ever read (or want to read), so you need a strategy to choose the most important.

In recent years, your optimal strategy should have included the papers by Carmen Reinhart and Ken Rogoff (see, e.g., this prescient paper from 2008). And so it is again in 2010.

This year’s installment is a paper that examines how government debt levels relate to economic growth and inflation. Their key finding? High levels of government debt have a substantial economic cost. In developed economies, that cost is weak economic growth. In emerging economies, that cost is weak economic growth and high inflation.

The growth findings are nicely illustrated in the following table from their paper:

Developed economies that have high levels of government debt (90% of GDP or more) have much lower rates of economic growth; for example, their median rate of growth has been a mere 1.6%, much less than the 3 to 4% growth of countries with lower debt levels. The same pattern holds for emerging economies, as well. (The third panel shows that high levels of public and private external debt also reduce growth, but the sample there includes only emerging economies.)

As R&R note, these results are particularly important today given the rapid growth in government debts around the world. In the United States, for example, debt will probably end the year around 60% of GDP, with no sign of stopping. The good news is that we are still relatively far from the 90% level that R&R identify as problematic. The bad news is that current policies will get us close to that level in less than a decade. For example, the Peterson-Pew Commission on Budget Reform recently projected that current policies would lift the debt-to-GDP ratio to 85% by 2018.